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November 1995
Volume 13, Number 11

Goodbye, Japanese "Miracle"
Jeffrey Herbener

Copy Japan! was the cry of the 1980s. That country, economically speaking, appeared to have it all: an industrial policy that knew good and bad investments before markets themselves did, a disciplined workforce, and, most of all, an unshakable banking system in which everyone had confidence.

Surveying the present wreckage, it's hard to believe these banks were once the envy of moneylenders worldwide. Now they have a reputation no better than the U.S. public school system.

Moody's won't give any Japanese bank higher than a C+ on its Bank Financial Strength Rating. The beauty of the BFSR is that it considers soundness apart from outside (read: government) assistance.

Some banks' stand-alone financial condition is much worse than their conventional ratings would suggest. Norinchukin Bank, which once rated a single-A, 3rd highest out of 9 grades, only pulls down an E in the new rating. The top 50 Japanese banks rank an average of D in their stand-alone status.

The D grade means "adequate financial strength but limited by vulnerable business franchise, weak fundamentals, or unstable operating environment." Other major banks, including Nippon Credit Bank and Chuo Trust Bank, have "very weak intrinsic financial strength requiring periodic outside support" or suggest "an eventual need for outside assistance."

At the center of these poor ratings are bad property loans estimated by Japan at $485 billion. Independent analysts say the figure could be as high as $775 billion. For fractional-reserve banks, always just a rumor away from insolvency, having to reveal their weak financial condition to the public is the kiss of death. Japanese bankers learned this the hard way.

But the cause of the Japanese banking demise still remains a mystery to conventional economic thinking. As Jesper Koll, an economist at J.P. Morgan Securities Asia, says, "Whoever resolves this recession will win the Nobel prize."

A nice idea, but the selection committee already gave the Nobel Prize to F.A. Hayek, in 1974. His expository work on the Austrian theory of the business cycle, first enunciated by Ludwig von Mises, tells us what we need to know. Japan's banking woes are a classic case study in the Misesian theory.

The boom-bust cycle is set in motion when the central bank inflates the money supply through the credit markets. Banks lend beyond the sum available from private savings, while central bank policy artificially pushes the rate of interest below its market level. Enticed by the lower rate, entrepreneurs borrow additional money to make capital improvements and expansions. Consumers borrow more to purchase durable goods, houses, and cars.

So it went in Japan. From the beginning of 1984 through 1988, the Bank of Japan increased bank reserves by 37.8%, causing a 38.4% increase in the narrow money stock. This monetary inflation more than doubled the yearly increase in narrow money compared to the previous five years: 7.7% compared to 3.4%.

The corresponding credit expansion was an alarming 45.2%, or 9% per year. Reflecting that trend, the short-term interest rate fell from 6.3 to 4.1%. The long-term interest rate fell from 6.8 to 5.1%.

Joy oh joy. All this central bank inflation and consumer borrowing set off demand for capital goods and consumer durables. Prices and profits rose leading to more production, higher wages, and more employment. The artificially low rate of interest increased the market values of all durable goods and claims on them such as stocks and bonds.

The Nikkei stock-market average exploded from 9,500 at the beginning of 1984 to 38,700 in 1990. To sustain this sonic boom, it became necessary to continually keep the interest rate below its market level. Only a central bank can accomplish this feat, and only through more inflation of money and credit.

The process of credit expansion swells the balance sheets of banks, while the volume of their loans increases. Unfortunately, the assets serving as collateral for these loans have market values artificially elevated by central-bank inflation. Moreover, as the boom progresses, loans are made to less and less creditworthy borrowers for more and more risky ventures.

The longer the central bank fuels the boom, the more financially unsound banks become. Meanwhile their actual condition is covered up by the artificially high prices of loan collateral.

But central-bank inflation can't hold the rate of interest below its market level forever. As borrowing for capital projects becomes unprofitable, and unaffordable for consumer durables, this boom is reversed. Prices also decline because of the increased rate of interest and drying up of demand for durable goods. The bust is in motion as prices and profits fall, resulting in reduced production and employment.

Despite continued efforts by the Bank of Japan to inflate money and expand credit (reserves increased 13% in 1989 and 7.4% in 1990), the credit crunch appeared in 1990. Short-term rates spiked up to 7.67% from their low of 4.1% two years earlier. These rates smashed the stock market from its peak of 38,700 in 1990 to 14,300 in 1992. Real estate prices took a similar plunge.

At this stage, the value of bank loans is squeezed from two sides: the ability of borrowers to pay them back is decreased, as is the value of collateral assets. Banks, like the industries which their loose money built up, must now undergo contraction to compensate for their profligate behavior during the boom.

If banks held 100% reserves, this would not sound the death knell. But for a fractional-reserve system, it's institutional death. Only the central bank can prevent total collapse. It must act as a lender-of-last resort. Yet, when the credit expansion of the boom has been particularly extreme, making good on all bad loans with monetary inflation is something the central bank dare not do for fear of hyperinflation.

The current level of bad debt in Japanese banks is estimated to be between 50 and 80 trillion yen, which translates to a 30 to 50% increase in the narrow money stock. The Bank of Japan simply cannot bail out the system with this level of monetary inflation.

This explains why the central bank only postures as lender-of-last-resort with promises to bail out bankrupt institutions when they collapse. At the same time, it must work behind the scenes to arrange mergers and loans among banks and taxpayer-funded bailouts.

While the deals are being cut, its only chance is to straddle the fence between financial collapse and hyperinflation. It must convince depositors to leave their funds in the failed institutions. Sometimes this works; sometimes it doesn't.

When depositors read reports of 180 billion yen in bad loans at Cosmo Credit Corp., Japan's fifth largest credit union, they rapidly shut it down by withdrawing 91 billion yen in three days, roughly one-fifth of Cosmo's total deposits. Auditors revealed later that bad loans, adding up to 360 billion yen, constituted 73% of its total loan portfolio.

To cover these losses, the Bank of Japan could only muster 19 billion yen to loan to Cosmo to meet depositors' withdrawals. Meanwhile, the government played the old con game: officials talked endlessly about the integrity of the system and how it would make sure that every depositor got his money.

The startling aspect of the Cosmo case is that Japanese credit unions are considered conservative lending institutions whose typical customers are small, local businessmen. But in a two-year period, at the height of the Japanese boom, Cosmo quadrupled its lending by extending credit to property developers. Such loans are particularly vulnerable at the onset of a recession, when rising interest rates, and expectations of impending recession, evaporate entrepreneurial and consumer demand for new construction.

The burst necessitates this type of activity to liquidate the capital projects and consumer durables production erroneously built up in the boom. Contraction of banks is part and parcel of this process and the counterpart to their unwise expansion.

During the easy-credit, windfall-profit boom, the central bank is beyond reproach. Only as contraction and liquidation are forced upon industries and banks do we see wailing and gnashing of teeth. That's when the Nobel Prizes are dangled like meat before dogs, so long as they dream up zero-pain solutions.

No such thing exists. Once a central bank creates a boom, the correct policy is strict laissez-faire. Interference in the liquidation process only prolongs and extends the inefficient use of factors induced during the boom. Under pressure from the U.S., however, the Japanese government is doing the wrong thing. It has decided to keep the con game going by expanding deposit insurance.

If we really wanted to prevent system-wide bank panics, and iron out the business cycle, the ideal solution would be to eliminate central banking and fractional-reserve banks. A pure gold standard and truly competitive banking would take their place. The Japanese case shows why anything short of that sows seeds of economic destruction.

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Jeffrey Herbener teaches Economics at Grove City College

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